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Why Index Funds Are Like Subprime CDOs

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Re: Why Index Funds Are Like Subprime CDOs

#181

Post by darawk »

Burry is making a terrible case, and he's fundamentally wrong on basically all counts.

> And now passive investing has removed price discovery from the equity markets. The simple theses and the models that get people into sectors, factors, indexes, or ETFs and mutual funds mimicking those strategies -- these do not require the security-level analysis that is required for true price discovery.

Passive investing is, for the most part, not funging against dollars that would have gone to high quality asset managers. It is removing noise in the form of retail speculation from the market. Asset managers that consistently beat the market (i.e. facilitate price discovery) have no problem raising capital.

> “In the Russell 2000 Index, for instance, the vast majority of stocks are lower volume, lower value-traded stocks. Today I counted 1,049 stocks that traded less than $5 million in value during the day. That is over half, and almost half of those -- 456 stocks -- traded less than $1 million during the day. Yet through indexation and passive investing, hundreds of billions are linked to stocks like this. The S&P 500 is no different -- the index contains the world’s largest stocks, but still, 266 stocks -- over half -- traded under $150 million today. That sounds like a lot, but trillions of dollars in assets globally are indexed to these stocks. The theater keeps getting more crowded, but the exit door is the same as it always was. All this gets worse as you get into even less liquid equity and bond markets globally.”

Trading volume != liquidity. They are related, but only indirectly. Liquidity is, for the most part, provided by market makers. Market makers are entities willing to take both sides of orderbook at all (or almost all) times. Most of the time, when you trade a stock, your counter-party is a market maker. Even if nobody is trading, that market maker is still providing liquidity. The liquidity is there, even if no shares are changing hands.

Where this gets tricky is that market makers make their money by trading. If there is less volume, they may be willing to provide less liquidity. But it's not at all clear that this is a real problem yet, or that there is any major crisis of liquidity in the markets. The correct way to measure this is not to look at daily volume, but at slippage. How much does the market move when you attempt to buy a large block? I'm not certain, but I don't think this is a major problem for people right now.

Re: Why Index Funds Are Like Subprime CDOs

#182

Post by human20190310 »

colechristensen wrote: post #178
markbnj wrote: post #58

Not knowledgeable on these matters, so my money is in index funds. Obviously a lot of other people are in the same category as myself. The article seems to be saying we'd all be better financial citizens if we put our money into actively managed funds, or did our own investing. The latter is out of reach for most people, and with respect to the former it's somewhat puzzling that managed funds can't consistently outpe…

The market is in peril because there are too few actors setting value based on the merits of the company instead of betting on other investors' behavior. You want to help? Pull some, not all but some assets out of index funds and put them into individual companies you understand and believe have long term profitability. Sell those assets when you think they're overvalued by the market. Trading less often is correlate…

> put [your money] into individual companies you understand and believe have long term profitability

If anyone was able to do this, they'd be a successful money manager themselves. Yet few professionals actually manage to do this at all, let alone sufficiently to justify their fees, which is why index-fund investing is so popular in the first place.

The only real way to reduce the reliance on index funds is for professional investment services to become sufficiently competent that it makes sense to use their services. Asking the average person to "take one for the team" and throw their dart at the same dartboard the pros can't even hit isn't a great solution.

[EDIT: phrasing]

Re: Why Index Funds Are Like Subprime CDOs

#183

Post by peteretep »

drelihan wrote: post #127
markbnj wrote: post #58

Not knowledgeable on these matters, so my money is in index funds. Obviously a lot of other people are in the same category as myself. The article seems to be saying we'd all be better financial citizens if we put our money into actively managed funds, or did our own investing. The latter is out of reach for most people, and with respect to the former it's somewhat puzzling that managed funds can't consistently outpe…

Imagine there was a cookie market made up of two types of cookies, tasty and meh. An active investor in cookies would spend time determining which cookies are likely tasty and which are meh. They would pay more for the tastier cookies so they can savor the flavor and less for the meh ones they can binge eat in the shower when no one is home.... A passive investor comes along and says, I don't want to do all this rese…

> At some point, no one is left to figure out which cookies are tasty vs meh

Except that there’s a lot of money to be made by figuring out which cookies are winners, and buying them cheaply to sell to the passive investors.

Re: Why Index Funds Are Like Subprime CDOs

#184

Post by dfabulich »

ptero wrote: post #140
markbnj wrote: post #58

Not knowledgeable on these matters, so my money is in index funds. Obviously a lot of other people are in the same category as myself. The article seems to be saying we'd all be better financial citizens if we put our money into actively managed funds, or did our own investing. The latter is out of reach for most people, and with respect to the former it's somewhat puzzling that managed funds can't consistently outpe…

I will try to interpret, but obviously it is just my interpretation (and personally I mostly agree with many theses Burry gave). First, he does not really talk about being a "good citizen" or not. His points are for "greedy citizens" who, in his view, should be worried (about his pocketbook) if he is heavily invested in passive index funds. This is due to his "bigger and bigger crowds, same exits" analogy: individual…

That doesn't answer markbnj's question. You elaborate why the passive market is in peril (because in the event of a sell-off, the ETFs will be forced to sell a bunch of low-volume stocks, crashing them), but that's just explaining in detail that the market is in peril because not enough money is flowing to people who do a poor job of managing it.

But, granting that Burry is right and you're interpreting him correctly, what is the average person with a couple bucks to invest supposed to do instead of passive investments?

Surely we can't recommend actively managed funds, funds that don't even earn back their fees. And, if not passive investing, and not actively managed funds, then…what, exactly?

Re: Why Index Funds Are Like Subprime CDOs

#185

Post by darawk »

nickles wrote: post #131
motbob wrote: post #108

So there are two concerns here. One concern is a problem with a certain asset being inflated, in this case S&P 500 stocks, and the money you might lose if you hold those assets and their value goes down to normal. A second concern is the collateral effects of a bubble bursting: the inflated assets are tied into many other assets/instruments, and untangling the mess caused by a rapid bubble burst may cause a financial…

> A second concern is the collateral effects of a bubble bursting: the inflated assets are tied into many other assets/instruments, and untangling the mess caused by a rapid bubble burst may cause a financial crisis. This is really the main concern. The indexes these funds are based on include names that don't have any liquidity. This means 1) the price of the security is less likely to reflect its intrinsic value; 2…

I don't really see the problem here. Any reasonably competent quant can calculate a liquidity premium and factor it into their ETF arbitrage strategy. ETFs that trade illiquid assets should simply trade at a discount relative to their "last traded price" NAV commensurate with the liquidity risk they're assuming.

Re: Why Index Funds Are Like Subprime CDOs

#186

Post by omarhaneef »

jpalomaki wrote: post #160
omarhaneef wrote: post #106

A lot of people seem to have read this and think that Burry is worried that the indices are weighted by market cap. That is not the issue. The issue is that a large proportion of the index is smaller caps that no one bothers to look at and price properly, and yet massive amounts of money are in ETFs and other contracts that take a position on those smaller, less followed names. So these small names in the large index…

If the small cap valuations are totally wrong, shouldn’t some simple measures like P/E show it clearly? Edit: The P/E values on Russel 2000 seem to be almost double compared to S&P 500 [1]. Also some point out that the value is not correct as it leaves out negative earnings which are common among small caps [2]. [1] https://www.wsj.com/market-data/stocks/peyields [2] https://goldco.com/russell-2000s-price-to-earnings…

I think the point is people use the measures that you can clearly see easily (like the P/E), and therefore you don't go down to the level of the stock (oh, temporarily raised earnings, forecast for reduced earnings, and as you point out, negative earnings etc).

Note: this is not my argument, but what I understand Burry to be arguing.

Re: Why Index Funds Are Like Subprime CDOs

#187

Post by greenshackle2 »

beat wrote: post #95
piker wrote: post #83

Earlier quoted context omitted.

> a community dedicated to low-cost investing primarily via indexing Right or wrong, that must be one boring place. [Re: downvotes, The post was just intended to convey that the thesis of "put your money in the lowest cost index funds using an allocation formulatically dictated by modern portfolio theory, and don't touch it for the next 35 years" would be unlikely to provide much fresh content.]

A community consisting of people patting each other on the back for being so much more clever than everyone else is rarely boring to the participants. The fact that this explains a majority of self-selecting communities is purely coincidental, of course.

Including Hacker News, no doubt.

Re: Why Index Funds Are Like Subprime CDOs

#188

Post by candiodari »

ptero wrote: post #158
entee wrote: post #150

Earlier quoted context omitted.

So the result would then be something like the flash crash? I share your understanding of the article, it’s not about “index bad active good”, it’s about, “is there a problem when a lot of investors have to move quickly”. I wonder if there is some analysis of this during the last crash.

It could be more serious than the flash crash (again, just an interpretation). Flash crash gets resolved quickly and is transparent to non-participants because there is a lot of money willing to buy on dips. But fast trading money only buys and sells what they perceive to be highly liquid assets -- there are few things that scare them more than being stuck with an open trade. The scenario Burry describes is akin to C…

The fundamental reason this happens is that Index Funds aren't "real" stocks. You cannot really sell SPY. There is a bucket of shares owned by SPY. Those contain shares of the index' companies. There's an "owned by clients" bucket and there's a "share liquidity reserve" bucket (with shares of companies in the fund). There's also a (small) liquidity "bucket of cash".

And of course, that company can, subject only to it's own chosen limitations, "print" SPY shares and sell them. So there's never any shortage of those.

When people transact in SPY, the trades are satisfied from those buckets. The cash bucket for investors selling SPY, the reserve shares bucket for investors buying. Those buckets are then refilled by the firm behind SPY buying and selling shares so that their share reserve and cash reserve remain at useful levels.

But let's now say there's heavy selling, for whatever reason. Sells really exceed buys and ... the cash bucket runs dry. Well, now sales stop, potentially indefinitely. The company will try to refill that bucket quickly, but there's absolutely no guarantee they will succeed, and there's no timeframe. Because the price for redemptions is only determined when they refill the bucket, you have no control over when this price is determined. It could be days after your order went through. Most index funds also technically have the right to just suspend redemptions entirely, indefinitely. Because of the amount of money in index funds, this will exhaust liquidity on actual shares relatively quickly and the whole market will freeze (because: no buyers)

Burry's claim is that if this ever happens, and investors find themselves stuck in index funds with no way out, there is nothing that will resolve that situation. Buyers won't want in, because once in, no way out. Sellers will panic and REALLY want out. This situation will self-reinforce until the market is driven into the ground.

0. some random situation causes that sellers exceed buyers for an index fund enough to initially exhaust the liquidity buffer of that fund

1. liquidity buffer in an index fund is empty

2. because of this transactions in the index fund stop

3. this causes panic, meaning less buyers, more sellers

4. goto 1, with situation getting worse every iteration

It won't be a "flash" crash, you'll just be locked in your index funds until the crash is complete.

It's hard to argue that this situation is impossible, that it cannot develop. It also seems to me that his conclusion that if this ever happens, it'll self-reinforce is correct. That said, we are pretty far from this happening.

Re: Why Index Funds Are Like Subprime CDOs

#189

Post by throw0101a »

markbnj wrote: post #58

Not knowledgeable on these matters, so my money is in index funds. Obviously a lot of other people are in the same category as myself. The article seems to be saying we'd all be better financial citizens if we put our money into actively managed funds, or did our own investing. The latter is out of reach for most people, and with respect to the former it's somewhat puzzling that managed funds can't consistently outpe…

> The article seems to be saying we'd all be better financial citizens if we put our money into actively managed funds, or did our own investing.

The evidence shows that most of us suck at investing. Further, I think Burry's critique is more limited:

> One reason he likes small-cap value stocks: they tend to be under-represented in passive funds.

IMHO, the problem he's stating is that people are focusing on large-cap companies. Basically the S&P500. And the S&P500 index funds probably do hold most of the passively invested money. But to solve this (small- vs large-cap focus), the solution is not to throw away passive investing, but to change the focus.

For example, instead of buying Vanguard's S&P500 fund (VOO), to buy their Total Market fund (VTI) which uses the CRSP U.S. Total Market Index:

* https://en.wikipedia.org/wiki/Center_for_Research_in_Securit...

Or perhaps a fund that uses the the Russell 3000 or Wilshire 5000.

* https://en.wikipedia.org/wiki/Russell_3000_Index

* https://en.wikipedia.org/wiki/Wilshire_5000

It's just that the S&P (and DOW) have more name recognition.

But generally speaking, these decisions are micro-optimizations. Just put away a little every month and re-invest and dividends, and over the long-term you'll do well.

Re: Why Index Funds Are Like Subprime CDOs

#190

Post by atemerev »

There is no such thing as free money. There are no such things as riskless passive investments that beat the reference market rates (which are close to zero these days). Therefore, index funds carry risk. Therefore, somebody (the bulk of index fund investors) will have to absorb these risks. All of this is nearly obvious.
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